Operational Risk for FRM L2 (Part 1/2)

By Shivgan Joshi http://stockcreditfinancecfa.blogspot.in/

Disclaimer
All terms like FRM are copyright to GARP Institute This video is intended to learning, research and reporting about FRM Exam I dont represent FRM Institute, Nor I am authorized trainer or endorsed by GARP/FRM I dont claim or guarantee accuracy of the information

About the Author

Instructor has 70% score on BAT, in aprox top 90 percentile globally Cleared CFA L1, FRM L1 exams Have experience of teaching on Wiziq, taking classes on GRE and GMAT for the past 1 year Websites www.freegregmatclass.com stockcreditfinancecfa.blogspot.in

Index
Economic Capital Modeling Model Risk Liquidity Risk Enterprise risk management Risk from Loss of Data Distributions, Analysis & Fitting of Operational loss data 7. Dealer Bankers & BASEL Class 2 8. Risk Aggregation
1. 2. 3. 4. 5. 6.

Introduction
Overview of the exam Sensitizes you with various topics

Economic Capital Modeling

RAROC= (RevenuesELExpenses+Return on Economic capital+- Transfer price)/EC Capital Attributed to 3 Risks Credit capital charge= capital factor * market value of position Risk Aggregation: 5 methods Two of them which are interesting are: Variance Covariance method Copula: combines marginal probability into joint prob

Spectral & Distorted Risk Measure

Risk measures Most famous risk measure is VAR http://en.wikipedia.org/wiki/Distortion_risk_ measure http://en.wikipedia.org/wiki/Spectral_risk_m easure

Variance Covariance matrix

Risk aggregation http://en.wikipedia.org/wiki/Covariance_matrix
Image source wiki

Model Risk
Quantifying Model risk Unknown parameters, correlations, mixing, and distribution risk Unknown parameters have Chi Square distribution

Liquidity Risk
Liquidation value of Assets Complex Formula Cost of liquidity Risk

Funding Risk http://en.wikipedia.org/wiki/Gini_coefficient http://en.wikipedia.org/wiki/Lorenz_curve

Quant of liquidity risk

LVAR/VAR 1. Mid value for spread 2. Stochastic Spread Endogenous prices Use elasticity term, LVAR=VAR*(1-E*( N/N)) E=( P/P)/( N/N)

Distributions used for OR

Understanding Extreme Value theorem Exponential distribution Weigh bull distribution Gamma Distribution Lognormal Pareto Distribution (heavy) Each with cases when to use which plus little of quant of them http://en.wikipedia.org/wiki/Extreme_value_theory

Loss Distribution Approach (LDA)

Weighting data points Frequency distributions Severity Parametric tales using Peaks over thresholds and Generalized Pareto Distribution

Freq and Severity convoluted to get final loss distribution

Risk from Loss of Data

Operational data tough to get Standard error for non parametric estimator: (1/f(q))*(p(1-p)/n)^0.5

Extrapolation using EVT & GPD

Analysis of Operational Loss data

Tail Plots: Log (1-F(x)) vs log x where x is data points and F() is the distribution function Mean access plots: Subtracting threshold from average the average of all loss greater than threshold Fitting distribution of Operation Loss Data Peaks over threshold Hill estimator

Analysis of Operational Loss data

Tail parameter estimate: HKKP (research papers): E( (k))= +ck The graph of tail parameter estimator for various k is referred to DedH plots Hill Plots
Heavy Tail Burr Loggamma Loglogistic Pareto-GPD Light tail Exponential Gamma Log normal Weibull

BASEL 2
Three options for credit Risk 1. Standardized Approach 2. IRB foundation 3. IRB advanced Three Pillar 1. Min capital requirements: Quant assessment 2. Supervisory review: Formal role of regulators 3. Market Discipline: Disclosers for regular capital requirements Tier 1,2, 3 capital

Standard error for non parametric estimator

f=the probability density function Qp = the quantile associated with the probability

1 SE f (q p )

p(1 q) n

Capital requirement for credit risk

Capital requirement (K) = (conditional EL EL) * (maturity adjustment)

downturn LGD N{

1 R G ( PD) G (0.999)} LGD..... 1-R 1-R

Market Risk Capital Charge

Liquidation Value of assets

LVAR/VAR
Formula

DedH
Rejecting null hypothesis that underlying distribution for loss data is light tailed

HKKP
Hill estimator

Class 2
Class 2: Alternative OR, Loss data, BASEL 2 &3, Risk Aggregation, Enterprise risk management

Conclusion
10 minutes introduction to FRM Operational Risk Module 1 of 2

References
FRM GARP reading info